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Understand fatal flaws of Fundamental Analysis

One group of people use Fundamental Analysis to choose stocks to buy or sell. The are called ANALYSTS, and they forecast future share prices based on a company’s expected operating performance, usually the next few quarters’ profit. Estimates of financial results are based on revenue and cost forecasts, supported by industry and country analysis, drive these profit figures. While the process sounds logical, it is inherently difficult to forecast the future, even for stable industries like beverages and utilities.

Research of price changes and analyst forecasts shows that analysts are generally poor in forecasting share price movements – their performance is no better than random.

One fatal flaw is that share prices already contain embedded expectations of future performance but it is not possible to know what these expectations are. If a certain improvement in revenue or cost is already expected, the share price of the stock will not rise even if its fundamentals improve. The share price will move only if a new item of information is a surprise.

Another reason for analyst’s poor track record is that they usually focus on the financials, without a deep understanding of the company and industry, and they rarely uncover new information. Example: Many companies have gone bust without the analysts even having an inkling of it.

A third reason is that analysts are poor in forecasting the general trend of the economy. Most recessions and slow downs are not predicted by analysts. For example, analysts generally did not expect the housing meltdown in the U.S. and the subsequent stock market crash. Most stock analysts were still sending out buy signals.